Note: this article is part of our collaboration with Filmynomics. To find out more about the consequences of the 2008 Financial Crisis and how it affected people worldwide, please read their article here: https://www.instagram.com/p/CToYddwgX_t/
Introduction
The Financial Crisis of 2007 and 2008 led to the Great Recession (2007-2009), the worst economic downturn since the Great Depression of the 1930s. Additionally, the financial crisis caused the failure of multiple major investment and commercial banks and nearly caused the collapse of the international financial system. It is safe to say that everybody was impacted by the Financial Crisis in one way or another. What could have caused such a devastating crisis?
Role of the Federal Reserve (Fed)
Between May 2000 and December 2001, the Fed decreased the federal funds 11 times—from 6.5% to 1.75%. This meant that consumer banks were now able to offer low-risk borrowers lower interest rates. Furthermore, the lower federal fund also meant that banks were encouraged to lend more to high-risk borrowers, albeit at higher interest rates. As bank loans became easier to acquire, the housing market began gaining attention. People used these loans to purchase more expensive homes, causing the prices of homes to skyrocket. This created a so-called “housing bubble.”
Commercial Banks Perpetuate the Crisis
The “housing bubble” problem was aggravated because changes were made to the bank laws in the 1980s, allowing banks to offer mortgages with “balloon payments”. Loans with balloon payments have the largest payment of the loan due towards the very end of the loan period. As the prices of houses continued to increase, people who could not pay off the loan were able to borrow more money against the value of their homes. If these people were still unable to pay off the loans, the bank could resell the house for more than it was originally worth.
Banks often sought to make profits, therefore more banks adopted the practice of giving mortgages to high-risk customers with few assets. The banks would take advantage of these customers, as they knew that they would not be able to repay the loan. Such mortgages are known as subprime mortgages and are often viewed as the main cause of the crisis by economists.
Securitization by banks
As the number of subprime mortgages and other consumer debt began piling up, banks started to sell these mortgages in capital markets as bonds (securities) to other banks and investors. Purchasers of bonds that were primarily based on mortgage-backed bonds (mortgage-backed securities, MBSs) were entitled to receive shares of the payments made on the original loan. By selling MBSs, banks could increase their liquidity and reduce the number of risky loans they owned, while banks that were purchasing MBSs could “diversify their portfolios and earn money.” As the housing prices continued growing, MBSs became increasingly popular.
Merging of Banks
In 1999, the Depression-era Glass-Steagall Act was repealed. This act prevented banks and insurance companies from involving themselves in each other’s markets and merging. The repeal led to banks growing and becoming “too big to fail.” In 2004, these huge banks were stimulated to buy and sell even more MBSs because the Securities and Exchange Commission decreased the ratio of capital that banks were required to have, preventing insolvency. This became problematic because the value of the MBSs was reliant on the indefinite increase of housing prices.
Overconfidence of the people involved
Overall, government officials, economists, and bank executives were convinced that financial crises were things of the past due to the long period of global economic stability and growth. They believed the business cycle of a period of economic growth followed by a recession had finally been overcome. This meant that almost everyone was oblivious to the clear signs of the imminent financial crisis.
Conclusion
In summary, the 2007-2008 financial crisis can be attributed to a variety of factors. Although economists are still debating on the exact breakdown of the factors, and to what extent they were responsible, many people believe subprime mortgages and the banks’ risky behavior as the main cause. Do you agree?
Sources
Duignan, Brian. Financial crisis of 2007-2008, accessed through https://www.britannica.com/event/financial-crisis-of-2007-2008 (05.09.2021)
Jickling, Mark. 2009. Causes of the Financial Crisis, accessed through https://ecommons.cornell.edu/bitstream/handle/1813/77536/R40173_20090129.pdf?sequence=1&isAllowed=y (03.09.2021)
Field, Anna. 2021. What caused the Great Recession? Understanding the key factors that led to one of the worst economic downturns in US history, accessed through https://www.businessinsider.com/what-caused-the-great-recession (03.09.2021)